How irrational behavior of individuals affects the economy

Many individuals do not understand the impact their everyday behavior has on the economy. It is the decisions of people that can lead to both economic prosperity and loss. At a relatively smaller scale, irrational behavior can affect one’s health and overall well-being. That is why it is paramount to know how to behave rationally when it comes to finances by learning about different types of irrational behavior:

1. Cognitive Bias

-Cognitive bias usually occurs when we behave irrationally, but frequently are unaware of our own irrationality. Our decisions are often based on impulsive responses. For instance, if we had one bad experience driving a specific type of car, we are likely to avoid using it again in the future.

-Another form of cognitive bias is when people stick to a certain product or firm, not considering other possible choices. This happens because of the overwhelming variety that exists in the modern world and because most people are inclined to be resistant to changes.

2. The herding effect

The herding effect occurs when one starts to think that the majority is correct and begins to follow the actions of others.

3. Irrational exuberance

Irrational exuberance is a way to describe over-optimism, especially about the asset bubbles. For example, if shares rise in value and people see an increased level of wealth, they become overly confident in their assets; whereas irrational exuberance is often a factor behind the financial crises.

4. Discrimination in the workplace

If a firm refuses to hire a qualified worker just because of appearance factors, then that company deprives itself of the profit the good worker could bring.

5. Sunk Cost Fallacy

Imagine that one bought a house that has become unprofitable to maintain. However, instead of selling it and cutting his or her losses, a person keeps it because of the strong attachment to the past decision that she or he made.

6. Present Bias

Present bias occurs when one chooses to put a greater emphasis on short-term spendings, ignoring investments or future costs.

The impact of irrational behavior

Now that different forms of irrational economic behavior have been described, it is time to talk about their impact on the economy and individuals.

1. Market failure

Irrational behavior can lead to an inefficient allocation of resources in society. If, for instance, people get into financial bubbles, the outcome may be devastating not only for an individual but for the economy as a whole.

2. Nudges

If individuals are prone to irrational decisions, governments and firms can make use of it. In a positive way, governments may ‘nudge’ consumers into better behavior. In a less positive way, though, firms can reinforce consumers’ impulsive behavior (e.g. chocolate at checkout counters) and make more profit.